Brynjolfsson: The Armored Wolf in pursuit of alpha

FM: You’ve written extensively on the U.S. Federal Reserve’s actions over the past few years. Would you share your current economic overview and outlook?

JB: The two-trillion-dollar question is “exit strategy.”

The Fed is capitalized with $55 billion of “paid-in capital.” The actual number may be much larger or much smaller than this, [because] implicitly the Fed has the backing of the Treasury and taxpayer (Yup, it’s too big to fail!), and also has implicit obligations [that] are unstated. But, I like to begin at least with the “facts” as they are stated, in this case on the audited financials of the Federal Reserve System. So by any measure, $3 trillion of assets on the Fed balance sheet is a lot of leverage. What leverage does is amplifies swings, or puts entities on the knife’s edge. That doesn’t per se speak directionally to inflation or deflation. What it speaks to is the following:

Low volatility “great moderation” is obviously behind us, as 2008 proved. However, it also is likely that the low volatility, inflation pegged at 2%, current environment will not endure. Markets are too complacent if they think interest rate moves are measured in basis points and inflation ticks up or down 0.1% a month to peg inflation at 2%.

Disinflation is certainly a possibility, as monetary policy is largely pushing on a string, and fiscal policy (with debt-to-GDP in the United States and most developing countries at over, or near, 100%) is hamstrung. Therefore there is little ability of the economy to respond to a negative macroeconomic shock.

Right now the United States seems to be motoring along, with pent-up demand and low interest rates, being roughly offset by headwinds created by fiscal tightening, the combination of tax hikes and spending cuts.

China, Japan and Asia more generally face headwinds to growth and are slowing. In China, secularly, we are seeing slowing from [an] historic rate of 10% to 12% being recalibrated toward a more sustainable 6% to 8%. But within that secular range, we are seeing inflation flare up, from 1.8% last fall to 3.2% now. That has triggered policy tightening in various forms, and in this sense is running somewhat counter to cyclic and policy dynamics elsewhere. Japan is facing slowdown, though it has a new, almost experimental, radical policy easing being promised and implemented at this time.

Europe is a basket case, and has already experienced a recession characterized by negative real GDP growth, falling inflation and rising unemployment among young and old, periphery and core. The macroeconomic challenges, an uncompetitive exchange rate, combining with dysfunction of the labor and capital markets brought about by befuddled policy, are being strained by political challenges. The uncertainty created by political forces, both those centrifugal forces pulling the Eurozone apart, and the domestic forces within nations created by the wealth disparities, unemployment, and austerity imposed on large populations, make capital formation almost impossible.

Inflation, longer term, that once started, accelerates and is difficult to harness is the biggest risk I see. The geometry of the situations is multifold, but with every aspect pointing to higher inflation.

First, you have a fundamental backdrop of growing demand, particularly in emerging market nations, for a finite supply of raw materials. Food, minerals, land, even fresh water. As these populations migrate to cities, urbanize and increase their incomes from current subsistence levels, their demand for commodities personally, and in their industrial efforts will multiply, while supply grows arithmetically by a percent or two, if not shrinks.

Second, you have extremely easy monetary policy, for unprecedented periods. The ease is measured by the real Fed Funds rate. Normally, the Taylor Rule, history and other models of real interest rates, suggest that a “neutral” real Fed Funds rate is +2%. So the Fed Funds rate may be 4%, inflation may be 2% and the difference, the real Fed Funds rate +2% would be considered “neutral.” During periods of overheating, typically a +4% real Fed Funds rate has been required to “put the brakes on” and cool an overheating economy, or accelerating inflation. During periods of weakness, when inflation falls, unemployment rises and real GDP growth hovers around zero or less, a stimulative real Fed Funds rate of 0% is required. Over the past four years the real Fed Funds rate has gravitated down to –2%, and QE (the balance sheet expansion of the Fed, and other central banks) has amplified this by extending the negative real money market rates out the curve into the seven-, 10-, and even 30-year sectors of the bond market.

Third, you have the difficulty in exiting. Fighting accelerating inflation is always hard. You have the normal political pressure (from presidents, senators, representatives and other politicians up for election) to accept the bargain of short-term gain through easy policy, at the expense of much greater long-term pain associated with high inflation. But currently the huge balance sheet, unprecedented not just in size, but [also] in the maturity and low coupon of the fixed-rate securities holds. On a mark-to-market basis, these could wipe out Fed capital with a small rise, 40 basis points or so, of market yields! Though not marking to market is optically preferable, it doesn’t change the reality. In particular, the mark-to-market simply quantifies the ongoing cost of carry securities with low, long-term, fixed coupons. Similarly, whether the Fed exits by selling securities, or instead finances them at somewhat higher short-term rates (needed to offset the inflationary effects of the Fed continuing to hold large quantities of long-dated Treasuries on its balance sheet) the cost is roughly the same. The challenging financial position that the Fed will be put into by these dynamics will erode [its] political independence, at best. As an investor, I think it prudent to register the increased inflation risk associated with this unusual situation, particularly because current policies only increase this dynamic.